Monday, November 30, 2015

Siobhan Austen and Darren O'Connell — Nobel Laureate Douglass North’s work leaves a strong legacy for economics

North focused on economic history in the belief that we need first to develop an understanding of what determined the performance of economies through time before we can an attempt to improve their current performance.
North’s analysis of the economic performance of nations focused on the role of institutions. He asserted loudly that institutions matter. Indeed, he argued that institutions are the underlying determinants of economic performance; more important that other factors commonly ascribed key roles, such as changes in technology or relative prices.
Institutions are “the humanly devised constraints that structure human interaction”. They comprise all those elements of the social environment that regulate how we can interact with each other. Institutions include laws, rules and constitutions, as well as social norms and conventions.
North argued that institutions matter for economic performance because they affect transaction costs. Transaction costs include the costs involved in designing, negotiating and enforcing trade contracts; the formal and informal contracts involved in buying and selling goods and services. When institutions are missing or weak; for example, when laws are poorly specified or not enforced, the costs and risks of engaging in trade will be high and the prospects for economic expansion will be low.…
In later work North applied his notions about the importance of institutions more broadly and ambitiously. For example, in collaboration with John Wallis and Barry Weingast in 2006, North attempted to use institutional theory to reinterpret the last ten thousand years of human history. They described how the formation of small groups of elites and militarised coalitions within tribes limited outsiders’ access to land, labour and capital within territorial zones, and protected valuable activities such as trade, worship and education.
This generated rents for elites, which, in turn, encouraged cooperation, specialisation and trade – rather than warfare - between neighbouring territories. North and his colleagues argued that this equilibrium proved both profitable and persistent, to the extent that “limited access orders” came to dominate the behaviour of these societies; that is, the stable state became the de jour “natural state”.
An important theme in this narrative is that institutional change is likely to come about when powerful economic or political agents perceive that they can capture additional gains. This reflects North’s close ties to the rational choice tradition, which suggests that institutions evolve in response to the needs and interests of individuals. However, North also recognised that people’s perceptions are influenced by their current cultural context and flows of information. He argued that the development of institutions and economies will be “path dependent” - constrained by the existing set of institutions and incentives – and not necessarily, or usually, optimal in terms of economic efficiency. North emphasised that time matters in the determination of economic performance, as well as institutions.
The interesting thing is that North worked within a neoclassical framework to show that neoclassical assumptions about the "invisible hand" of natural market forces leading to spontaneous order is wrong. History, culture, institutions, and organizations are key economic factors.

The Conversation
Nobel Laureate Douglass North’s work leaves a strong legacy for economics
Siobhan Austen, Associate Professor, School of Economics & Finance, Curtin University, and Darren O'Connell, Sessional Lecturer, Curtin University

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